Trading and investing in the financial market involves the risk of loss. But risk can be managed by using hedging techniques based on the type of asset and market conditions.
Hedging is a risk management strategy in which you protect your future profit or limit losses of one asset by purchasing or selling another. Most market participants trading in options are using hedging strategies to manage their trade.
Option is a derivative contract which gives the buyer or owner the right, but not the obligation, to buy or sell a stock or other financial asset at a fixed price and time.
Hedging is basically an offset position in a financial asset or investment to reduce the price risk.
Producers or suppliers of various commodities also use hedging to control the future price of the commodity like crude oil, sugar, natural gas, silver, gold, cotton and currencies that they use in their day to day business.
Example of Hedging
Let us understand what is hedging and how it works with an example.
Suppose, Mr Kumar is holding 1250 shares of a listed stock at Rs 100 per share. At present he has an unrealized profit of Rs 12,500.
Now due to market conditions, Mr Kumar is thinking that the stock price will go down for a few days if he holds on to the shares. He has two options: either sell the shares at current price and buy back again at a lower price after 15-20 days or use hedging strategy to make money while stock prices are going down.
To hedge, Mr Kumar can buy a put option of the same stock at a strike price close to the current market price of the stock. Put option gives the buyer or holder the right, but not the obligation, to sell the underlying stock at a fixed price on the date of expiry. In the case of American option, the put option can expire on or before the date of expiry.
In this case, Mr Kumar decided to buy a put option of 1250 shares for Rs 80. Let us assume he paid Rs 1 as premium to have the right of put option at a total cost of Rs 1,250.
If the stock price goes down and hits his expectation, he can exercise the option to get profit.
Instead of going down, if it stays at or near the same strike price or moves in the opposite direction, then he can let the option expire. In this case, he will lose only the premium paid for buying the put option.
This type of hedging strategy is referred to as proactive put.
Hedging strategies are mostly used in futures and options markets. Even strategically diversifying stock portfolios is a type of hedging, in which investors prefer to invest in different stocks from different sectors to minimize their risk.
What are the types of hedging strategies used in futures and options markets?
Hedging allows market participants to minimize their risk exposures.
Market participants use different hedging strategies based on the current and future market movements. Here is a list of popular hedging strategies used by market participants;
- Protective puts
- Covered calls
- Debit Spreads
- Credit Spreads
- Iron Condor
- Butterfly
- Straddle
- Strangle
Every hedging strategy has a cost associated with it. Therefore, before deciding which hedging strategy to use, you must decide whether the potential benefits justify taking the expenses.
